If current predictions about an M&A buyer’s market through the remainder of the year and into 2023 prove accurate, sellers may be forced to broaden the scope and recourse of their representations and warranties—the assertions made about the company’s business and financial condition in the purchase agreement.
A representation is an assertion of a set of facts provided by a seller to a buyer to induce it to buy the business. A warranty is the seller’s assurance that the representations are true, which is backed up by a promise of indemnity. If the assertions prove to be false, the warranty is considered breached and the buyer can make a claim against the seller’s indemnity and any money held in escrow.
Buyers typically require sellers to retain approximately 10 percent of the purchase price of the transaction in escrow for a year in case the assertions fail to hold water. Given the enhanced regulatory scrutiny of M&A transactions, many deals are taking longer to close. The added time increases negotiating expenses, impelling some buyers to increase the negotiated indemnity limit above 10 percent and extend the indemnification duration further than a year—assuming the seller is willing to along with these changes.
One way to achieve these aims is through a representations and warranties insurance (RWI) policy, a once-fringe product that has become increasingly mainstream. “Buyers can use reps and warranties insurance to extend the time period for recovery of losses beyond what is typically contemplated by an acquisition agreement [and] meaningfully shorten the time required to negotiate the acquisition agreement,” says Christopher R. Moore, M&A partner at law firm Cleary Gottlieb.
That’s good news for dealmakers, since few aspects of an M&A transaction are as heavily negotiated as the representations and warranties, which can easily take up a couple dozen pages of the purchase agreement. Deals often bog down over the breadth and scope of the seller’s representations regarding its business, talent, operations, assets, intellectual property, taxes, litigation, financial condition and so on.
“A benefit of the insurance is to alleviate key pressure points in the dealmaking process, as the parties spend inordinate amounts of time haggling over the scope, nature, amount and duration of the indemnity,” says Edward Markovich, head of the transactional risk group at insurer Chubb.
Other benefits for buyers include a longer duration of protection, versus a typical seller indemnity and a reduction in credit or collection risk. “Sellers typically stand by their statements for a year, whereas the insurance policy lasts between three to six years,” Markovich says. By reducing or eliminating the need for the seller to establish an indemnity and escrow, the insurance further addresses the buyer’s credit risk on the otherwise unsecured indemnity provided by the seller, he adds.
Toria Lessman, head of transactional liability at insurer QBE North America, says the insurance “also is a way to make the buyer’s bid more attractive in a competitive auction process, as the insurance seller helps reduce the escrow amounts and liability, giving the buyer another source of recovery for financial losses caused by a breach in the seller’s reps and warranties.”
Last, by mitigating the need for a buyer to pursue a claim against the seller if something goes wrong, the insurance preserves key relationships in the post-transaction environment, assuring a smoother transition. As Lessman puts it, “There’s no bad blood.”
These many benefits have resulted in an uptick in the number of reps and warranties policies sold. “We’re seeing a steady flow of business in the last couple months, including in sectors like healthcare and technology that for the most part hadn’t bought the insurance previously,” Lessman says.
RWI is not a panacea, however. The coverage excludes forward-looking statements and adjustments in purchase price. The cost of the insurance includes the premium and an underwriting fee paid to the insurer, due to the complex underwriting process. Nevertheless, Markovich says, the insurance “offers an incredibly neat and robust solution as we head into a buyer’s M&A market.”